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Setting the carbon price free

The dynamic of the political debate on climate change has shifted with Prime Minister Kevin Rudd today announcing that a Labor government will move towards an Emissions Trading Scheme (ETS) for the financial year beginning 1 July 2014, one year earlier than under the current Clean Energy legislation. This will raise significant issues for businesses in Australia.

Moving to an ETS from mid-2014 would mean carbon-liable companies could be paying less than $7 per tonne of 2014-15 emissions, based on current European prices, dramatically lower than the $25.40 fixed price scheduled for that year. Arguably the price paid by liable entities under an ETS would also be less than the Coalition would incur in funding its direct action plan, according to indicative prices released in 2009.

There appear to be three different scenarios that could play out in relation to the future of carbon legislation in Australia:

Labor wins the upcoming election (or possibly brings an early Parliamentary vote) and accelerates the start of the flexible price period to 1 July 2014;

Coalition wins the election and repeals the Clean Energy legislation, some details of their direct action policy are still unclear; or

for political or practical reasons there is no change to the legislation.

Making the changes

What needs to be included in the amendments to legislation?

The Government will need to pass legislation to convert the financial year starting 1 July 2014 into a flexible price year. Critically the changes must allow:

the setting of a carbon pollution cap for the financial year beginning 1 July 2014; and

linking of the Australian and European markets. While not necessary to move to an ETS, this will facilitate liable entities benefiting from a reduced European carbon price.

If the markets are to be linked, legislation would presumably be required to bring forward the applicability of “Surrender Restrictions” which set out the maximum number of international permits which may be surrendered from financial year. These state that a liable entity can only use international permits for up to 50% of its surrender obligation for the financial year beginning 1 July 2015 until the financial year beginning 1 July 2020. In addition there are further restrictions on certain types of international permits, for example, an entity may only surrender 12.5% Kyoto permits as these are seen as “low cost”.

Timing

Although, there is the possibility of an early Parliamentary vote, the timeline for Parliamentary sittings suggest that the Government could only pass the legislative changes necessary to move to an ETS if it wins the upcoming election.

Analysts have suggested either 19 or 26 October as the most likely election dates between now and November. If the Prime Minister chooses either of these dates, then both houses of parliament will sit between 20 and 29 August and, in the case of the later election date also between 9 and 12 September. This may not provide sufficient time to draft and pass legislation to make the required changes.

In addition, the Government faces significant difficulty passing any legislation that moves to an ETS early in the current Parliament as the Greens have indicated they would not lend support. Labor, without the Greens, even with the support of the two independents, controls only 33 of 76 seats in the Senate.

Setting the carbon pollution cap

Under the current scheme the Government must table Regulations specifying the pollution cap numbers for the first five flexible charge years of the carbon pricing mechanism (eligible financial years beginning on 1 July 2015, 1 July 2016, 1 July 2017, 1 July 2018 and 1 July 2019) on 31 May 2014. That pollution cap is to be based on the recommendation of the Climate Change Authority. As of 15 July 2013 the Climate Change Authority is considering submissions in relation to their first review of Australia’s emissions caps and targets. After a process which includes publishing a draft report in October 2013 the Authority is due to make a final report to the Government on 28 February 2014.

To facilitate an earlier flexible price period, and allow advanced auctions, this date may have to be moved significantly forward. The Government must release the number of units to be auctioned at least 15 days prior to the auction.

Contractual carbon cost pass through

The early move to a flexible price period is a timely reminder that companies need to ensure that their contractual pass through clauses can adequately address a situation where the price is no longer fixed.

Carbon pass through clause based on supplier’s actual cost

In clauses that are dependent on the supplier’s actual cost, difficulties will arise where the carbon price is flexible, and, potentially, not determined prior to the time payment is due under the contract. In these contracts determining the suppliers cost will rely on the definition of price in that contract. This may be determined by, for example, the average international price or a spot market price. Determining how a pricing mechanism works under a particular contract will require a case by case consideration of the carbon pass through clauses.

Carbon price inclusive contracts

Although they are less common, some contracts have been drafted to include the cost of carbon in the price a purchaser is paying. In these cases, the supplier may be the beneficiary of a windfall, because the contractual price includes a sum that is higher than the actual cost they are liable for under the flexible price period.

What can you be doing now to prepare?

Corporates with a significant carbon exposure should start looking at whether they are adequately protected in key contracts for a move to a flexible price period and, preparing carbon procurement strategies in anticipation of auctions; including:

potential procurement and auction strategy;

carbon trading and importation approaches; and

hedging and risk management strategies in this volatile period of change.